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24 February 2018

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ILS market prepares for Irma test

11 September 2017

Hurricane Irma will be a major test for the ILS market even though it has taken a more favourable westerly turn for the reinsurance industry, straying away from Miami.

But initial indications of interest in injecting post-event capital may provide a positive answer to the question that still gets raised about ILS capital's durability after a major loss.

"This is the chance to finally get some of the Luddites and naysayers off our backs," one fund manager said.

Even ahead of the storm's landfall, before the scope of Irma's losses could be known, ILS managers, investors and investment advisers were involved in discussions on potential capital raises.

The lure of higher rates already seems to have whetted investors' appetite, with one adviser saying that the topic of post-loss opportunities was a more interesting question than talking about the loss quantum.

"Irma is what it is," the source said, pointing out that this was precisely the type of event they would expect to be called on for.

But more to the point, he said, investors were starting to get excited about the potential opportunities being flagged by managers to write post-loss business - both immediate back-up covers and at the upcoming 1 January renewals - at more attractive rates.

In terms of the type of capital that will support post-loss underwriting, some said that the investors that will be able to move at sufficient speed to invest in writing back-up covers may not be as dominated by the pension fund money that has been the mainstay of the sector's growth in the past few years.

Family offices and endowment funds, as well as hedge funds, could be among those able to move faster to seize the opportunity.

"Pension funds are likely to be on the slower side, as they typically have several layers in their decision-making structure, unless they have already agreed a strategy on what to do when an event like this happens," another observer explained.

But, as others added, some pension funds active in the sector have already signed up for contingent capital funds.

Scale of losses

If Irma is a $30bn-$60bn loss, perhaps the question will be whether this makes the fundraising efforts harder, rather than easier.

The issue will be whether a more moderate loss scenario means there is less scope for a market correction, and reduced demand for back-up covers.

But one fund manager suggested that even a $40bn loss would be enough to dislocate the market, following closely on the heels of Harvey and other more minor losses.

Even though Harvey was not a typical ILS loss, it will contribute to tying up capital deployed in aggregate structures.

Regardless of the total ultimate cost of Irma, it is clear that any Florida event will have a disproportionate impact on the ILS industry relative to its overall market share.

Days before the storm's US landfall, ILS analysts said that modelled outcomes for ILS portfolios from a $125bn Miami hurricane-type scenario could easily have delivered losses of around 20 percent.

Losses would be more modest - in the 10-20 percent range - for lower- to mid-risk strategies, while 25-40 percent losses were possible in higher-risk reinsurance strategies.

However, others suggested these were too optimistic.

Retro strategies were expected to be the hardest hit. Sources said industry losses of less than $60bn could wipe out all retro capital.

Steep as some of the potential loss outcomes could have been before Irma swerved away from Miami, their impact on investors would have been softened by their overall small size in relation to an institution's broader investment portfolio. This point was made by Nephila co-founder Frank Majors in a roundtable discussion in an AM Best Monte Carlo report prepared and published before Irma.

"I would argue that an investor who has a 2 percent to 10 percent allocation to an asset class is in a pretty good position to be pretty rational," he said.

"It's not going to hurt them if they've got a 5 percent allocation and it's down 20 percent. That's down 1 percent on their fund. They can take a long view on that."

The debate also discussed the practice of ILS funds reinsuring each other.

Both Majors and RenaissanceRe Ventures head Aditya Dutt dismissed comparisons to the reinsurance spiral that built up at Lloyd's in the 1980s, as the obligations of ILS funds to each other would be fully funded.

Most ILS managers would only buy industry loss-based cover, although Nephila has for the last couple of years had some indemnity protection in place for its reinsurance book, as well as $410mn of Blue Halo cat bonds.

However, this is fairly modest in comparison to the $2.3bn of ILS cover Everest Re had lined up from its Kilimanjaro Re bonds, for example, not to mention the Mt Logan sidecar.

The cat bond market would be the first section of the ILS industry to benefit if Irma losses come in at around $50bn rather than the $100bn+ feared from a more easterly track. There are exceptions, but cat bonds are typically placed at the more risk-remote end of the spectrum.

This liquid side of the market makes up the smaller part of the ILS world at roughly $25bn-$28bn of an overall $80bn-$90bn of capacity.

Collateralised reinsurance written for the Florida carriers, retro quota share sidecars and retro aggregate excess of loss contracts are clearly still highly exposed to Irma losses.

Nephila, Everest Re and RenaissanceRe are the biggest carriers involved in the ILS space in the Florida market.

Aeolus is another major player and further behind are funds such as Securis and Elementum.

On the retro side, Markel CatCo does not write Floridian reinsurance but will have substantial exposure via its pillared retro product.


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